Usury and monetary policy

2011-10-17  / Andy Xie


Summary

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The bankruptcies of many private enterprises, especially in Wenzhou, are mostly due to speculation with borrowed money gone bad. It is totally wrong to characterize this phenomenon as monetary tightening squeezing SMEs. Normal businesses don't go bankrupt because they cannot borrow. Only money burning speculation needs to borrow constantly to stay afloat.

Loosening monetary policy now to ease the liquidity crunch for speculators would do enormous harms to the economy. Indeed, the excessive monetary expansion between 2008-10 squeezed real businesses through cost push and rewarded speculation through asset inflation. Another wave of excessive monetary expansion will magnify manifolds the speculation in China's economy by proving again that speculation, not honest business, is profitable. The ultimate crash will be much bigger.

High interest rate lending is turning into a ponzi game or 金融转销 in many tier II and III cities. The phenomenon seems quite widespread. Zhuanxiao is a constant threat to China's social stability. Financial zhuanxiao has disruptive power many times of the usual type. If not stamped out soon, it could cause widespread social instability next year.

China is facing manual labor and energy shortage. The ongoing economic slowdown is a good thing. Pushing growth would only worsen inflation. To achieve another wave of high growth, China must rebalance its economy away from manual labor and/or energy- intensive industries towards higher value added activities.


A good thing gone bad

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The underground lending has a long and productive history in China. It reflects that China's state-owned financial system couldn't meet all the market demand. Underground financing is a major force behind the export-led economic boom along the coast. The SMEs in PRD and YRD have benefited from the availability of financing through such channels. And they have been the main force in China's export boom.

Financing through informal channels is the main source of financing for SMEs throughout the world. Formal financial institutions just don't have the cost structure to service SMEs effectively. Hence, the government shouldn't stamp out informal financial channels because they sometimes create problems like now. Overall, informal financing contributes to the economy.

The nature of the underground financing in China has shifted in the last five years, away from real economic activities to property and financial speculation. The reason is obvious. Speculation has been profitable due to massive monetary expansion, while real businesses have been squeezed by weak global demand and rising costs.

Should we blame underground financing per se for creating the bubble? Not really. No financial institutions could go against the macro environment. Even the best managed banks rarely survive a loose monetary environment intact. Financial institutions are just not equipped to handle macro risks. The 2008 financial crisis and the current euro debt crisis demonstrate this point.

There is little doubt that China's banks have played a dominant role in turning monetary expansion into a massive property bubble. Underground lending has played a supporting role, often funding fake equity for qualifying for bank lending.


Macro tightening bridge loan?

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The lending rates in the underground financing market range between 20-100%. Hardly any business in the real economy has returns so high to afford such high interest rate. The borrowers of such high interest loans can only hope to repay the loans through asset appreciation.

For example, land owners have turned to high interest borrowing to hang onto their land holdings while the monetary tightening has limited the availability of bank loans. Many property developers view the tightening as temporary, like in 2008. Hence, they view high interest borrowing as a bridge loan for getting through the tightening window. When the tightening ends soon, as they expect, the land price would surge far more than the interest they would have to pay.

Extrapolating from the most recent past is always dangerous. The 2008 global crisis changed the Chinese government's mind from fighting inflation to supporting growth. The decision doesn't look so smart today. China's labor shortage was already obvious then. The stimulus has worsened inflation problem enormously, while the monetary growth, due to shortage of opportunities in the real economy, has primarily gone into property market. China is facing tremendous difficulties today because of the unwise stimulus policy then.

It would be extremely unwise to expect the government to loosen up and stimulate growth now. If so, it would be a bigger mistake than the previous stimulus, because the economy will experience even more excesses. Another stimulus package like the one in 2008 could trigger hyper inflation and hyper speculation in China. The consequence wouldn't be just another burst. It could lead wholesale political changes. It is difficult to imagine that the central government would take so much risk with little upside and so much downside.

Property developers that depend on high interest loans are making a huge mistake. They should resort to price cutting to increase sales rather than selling little at high price while depending on high interest loans for liquidity. The later they wake up, the deeper price cuts they have to do eventually. Of course, when the market clearing prices are 50% less than the recent peak, many developers would go under.

It is necessary for many, if not most developers, to go under. Unless it happens, the tightening wouldn't have worked. Otherwise, it would be business as usual, i.e., the economy depends on bubble making for growth.


High interest lending may have turned into a ponzi game

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While the demand from property market started the high interest lending boom, it seems to have turned into a Ponzi game or financial zhuanxiao lately. Because real interest rate is too low, stock and property markets are depressed, and the real economic activities have low profitability, savers have become credulous about opportunities like high interest lending. They worry their bank deposits are depreciating in real terms. Also, 20-100% interest rate has the smell of 'get rich quick'. There are always numerous people who are suckers for that. So many want to believe its sustainability and dream how rich they would be in a few years.

There are no activities in the real economy that could bear such high interest rate. Financial speculation doesn't look so either. The property market is declining. The stock market is depressed. So where could the high interest lending go?

In the past two months, I have travelled along the coast and up the Yangzi River. High interest lending seems booming. Even in interior cities commercials are everywhere advertizing the business. There are so many people involved, it seems. As the end demand seems dubious, I have to conclude that this business is now a Ponzi game, relying on new money to pay off the old money. I haven't seen anything before. It is quite scary.

A Ponzi game is a redistribution game. Unfortunately, the last ones to hold the bag are often the most vulnerable and credulous, like low income group and retirees, in the society. When they lose everything, they will turn on the government. There are plenty of examples from the past. The central government should deal with it now to control the risk. As this involves criminality, the central government should mobilize security apparatuses to deal with this.

China experiences pyramid schemes or chuanxiao (传销) frequently. The security apparatuses deal with it on a daily basis. This is the first time that chunaxiao has become a financial phenomenon. If not checked, it could lead to a national calamity.


Monetary growth is not too tight

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The current level of monetary growth is more than adequate for China's economy under normal circumstances. M2 grew by 13.5% in August from last year. It is much lower than 20% in recent years, but still considerably higher than China's potential growth rate. China's financial depth is already very high with total assets of deposit taking corporations above 2.3 times 2011 GDP. Hence, monetary growth above the potential growth rate of the economy will become inflation.

Also, the current M2 growth rate may be underestimating the true magnitude of monetary growth. Commercial banks have been active in off balance sheet activities in response to tighter lending restrictions. The trust sector has been booming. The underground high interest rate lending market has been surging. These activities are not fully reflected in the monetary statistics. If these activities are taken into account, I suspect that the apple-to-apple comparison would give us 16% broad money growth rate.


Inflation is still the challenge

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Inflation remains China's main challenge. The massive growth in money supply over the past decade is still turning into inflation. The level of monetary growth is not low enough to subtract from it. China isn't really pushing inflation back into the bottle yet.

The structural changes have made China's economy much more inflation prone. Three decades of one-child policy is cutting today's labor supply. China's manual labor supply may not be growing at all. Factory and construction drive China's growth. Unless the growth rate slows down significantly, labor shortage will wosen, increasing inflation as a result.

Energy shortage is another factor driving inflation. The official statistics may show China's coal consumption at 3.6 billion tons and, including production above government approved quotas, possibly at 4 in 2011. Double digit growth rate of coal consumption on such a large base is unsustainable. The transportation system won't be able to handle that. Also, the production levels in viable production locations may be peaking. China's growth model is highly energy-intensive. If the growth rate of coal consumption remains at double digit rate on such a large base, energy prices will continue to inflate.

While monthly inflation data may fluctuate and sometimes show cooling inflation, the underlying forces are still for inflation. It would be wrong to shift macro policy priority away from price stability.


Slowdown has little downside

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Unlike a decade ago, economic slowdown today has little downside. The shortage of manual labor is still worsening. A slowdown will hardly cause an employment problem. The SMEs that are going bankrupt may lead to layoffs. But, the affected workers can find jobs quickly elsewhere.

There is an employment problem for six million college graduates per annum. The wage gap between those with and without college degree is virtually not existent, at least at entry level. A large number of college graduates, unable to find satisfying white-collar jobs, are staying home. Considering how much they have cost their parents in going through four years of college, the current situation is not acceptable. It is a destabilizing force.

However, the answer to this problem isn't pushing growth. Construction and factory drive growth under the current model. It needs blue collar workers. The answer to the insufficient employment of college graduates lies in reorienting the growth model towards higher value added activities.


The way forward is rebalancing

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China's next growth cycle must be less labor and energy-intensive. Otherwise, inflation will surge to derail any growth push. China must reform its economy and give more power to market and private sector. The dominance of the state-owned enterprises inevitably leads to big project-led growth, which is too inflationary.

The starting point of rebalancing China's economy is to limit the revenues of the government sector. The fiscal revenue and SoE profit may reach 30% of GDP in 2011. The SoEs also spend considerable more than their profits on capital expenditure. Local governments also increase their net borrowings to increase spending. If these factors are taken into account, the government state may spend half of the money in the economy.

China's private enterprises and household sector have been marginalized in the past decade. China's consumption is a small share of GDP because the household sector doesn't have the cash flow to support higher level of consumption. Unless the government sector takes less money out of the economy and leaves more for the household sector, big project construction will continue to dominate the economy.

Also, the current economic structure gives profitable opportunities mostly to SoEs. Private companies are left with low margin businesses like light manufacturing and retailing. Only the property sector has delivered good returns mostly through land inflation. This is why so many private companies have moved into property development. As the property bubble deflates, the private sector will become much smaller.

The rebalancing of China's economy begins and ends with limiting the size of the state sector. Anything else is just diverting attention. To limit the government size, the first step should be to cut taxes. For example, the top personal income tax rate should be cut to 25% from 45%, and the VAT should be cut to 12% from 17%.

Through rebalancing, China's economy will shift to higher value added growth. Only then could China revive high growth rate without sparking inflation.


Deflating property bubble is the answer to tight liquidity

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The current liquidity problem, as reflected in bank lending restrictions and high interest rate in the underground financing market, is due to excessive demand, not supply too low. As argued above, the current monetary growth is more than sufficient under normal circumstances. The excessive demand comes primarily from the property sector. The properties under development may exceed 50% of GDP in value at last year's price.

The way out of the current liquidity problem is for property market to deflate. When the price comes down, the property market needs less liquidity.

Increasing money supply isn't the answer to the current liquidity problem. It will encourage speculation and exacerbate inflation, ultimately leading to an economic collapse.

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Posted in: monetary policy

Money shortage ?

2011-07-04  / Andy Xie


Summary

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The so-called money shortage today reflects excessive money demand in the past, which was a result of very loose monetary policy. If the tightening policy is changed due to the pressure, the monetary condition would go back to the excessively loose state. As inflation is still unstable, i.e., product or service price could jump by 20-30% in one go, loosening monetary policy could trigger hyperinflation and social turmoils.

There is a need to switch the tightening policy towards raising interest rate from just increasing bank deposit reserve ratio. The later only shifts interest rate increase into the gray market, which disproportionately burdens the SME sector. The current tightening approach protects local governments and SoEs that were the main drivers of the rampant money demand. Spreading the adjustment pressure through interest rate policy will help China achieve soft landing.



Liquidity tightness is necessary for controlling inflation

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Monetary tightening inevitably leads to the feeling of money shortage in the short term. Otherwise, the tightening cannot be effective. The tightening is caused by inflation. If nobody spends less, i.e., nobody feels liquidity pressure, how could tightening achieve its goal?

How could the tight feeling go away? The prevailing view in China is that the central government needs to loosen up. This is very wrong. When the businesses that shouldn't borrow and spend leave the scene, the tight feeling goes away. When a fat person goes on a diet, the hungry feeling goes away when the stomach becomes smaller due to a period of controlled diet. If the hungry feeling goes away with eating more, how could dieting work?

China's M2 is growing at about 16%. It is still high relative to China's potential growth rate. When an economy has low financial depth, i.e., low ratio of financial asset value to GDP, M2 could grow much quicker than GDP. But, China's non-financial sector indebtedness to financial corporations was Rmb 72.7 trillion in April or 182% of 2010 GDP. Fitch estimates that China banking system has off balance assets equivalent to 25% of its total. China's gray financing market could be another 25%. It is fair to say that China's non-financial sector has debts above 200% of GDP. This level of indebtedness is unprecedented for a country with $5,000 per capita income. So China has no excuse to grow money faster because the country has low financial depth.

As China's population ages, the potential growth rate is likely to trend from the current 10% to 5% by 2020. If China's M2 grows at 10% in 2020, the inflation rate would be 5%. So the 16% today isn't low. It feels tight because lots of borrowers should exit. Unless it happens, China's inflation couldn't get under control.



Inflation isn't under control yet

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China's inflation picture remains unstable. When the price of a product or service rises, it often goes up by 20 or 30%. This is rare in a normal inflationary environment in which prices tend to rise in line with CPI. The reason is because the stock of money supply is turning into inflation. China doubled its M2 in the past four years on top of an inflationary economy.

The government is taking some administrative measures to cool inflation. Cutting highway tolls, decreasing import tariffs, and jawboning businesses from raising prices could cool inflationary pressure for the time being. But, these measures only delay, not reverse the trend. If one interprets any cooling from such measures as victory over inflation and begins to loosen up again, a catastrophe will follow.

When someone has fever, ice could cool the temperature. If a doctor declares the patient cured, the patient's disease won't be treated. The problem will only get worse.

China isn't in a shape to loosen monetary policy whatsoever.

Some argue that China's inflation is only in food and energy, i.e., inflation is due to localized supply and demand balance, not loose monetary policy. This is very wrong. Services are inflating across the board. Even barber shops at street corners are raising prices. Rents are rising at double digit rate.

Lack of accurate data hampers the debate on inflation. If the statistics are not accurate, how could we have a meaningful debate? It would be catastrophic to declare victory by pointing at faulty data. Such a gesture will scare people into full panic.



The tightening mix should change

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The tightening so far relies on quantity restriction through increasing deposit reserve ratio. The interest rate hikes have been marginal. Hence, the demand for credit at the current interest rate exceeds supply. The imbalance is kept at bay through limiting credit access. The non-state sector has a tougher time to borrow than before. It leads to skyrocketing interest rates in the gray market. Hence, the non-state sector bears a disproportionate share of the tightening consequence.

The supply-demand imbalance has allowed the banks to raise lending rate too. The banks could increase lending rate by 30% above the policy rates. Further, through charging advisory fees and forced deposit back, banks can charge a lot more, even to the state owned enterprises.

China's tightening mix sacrifices savers. China's household sector has Rmb33 trillion in bank deposit. The current deposit rate is at least three percentage points too low, compared to the effective lending rate or inflation rate. The household sector is effectively subsidizing debtors, mostly SoEs and local governments, to the tune of over Rmb1 trillion per annum. It is equivalent to half of the total SoE profits in 2010.

The low interest rate policy isn't costless to the government. It keeps inflation expectation high and unstable. Chinese businesses used to be known for price competition. Increasing price at any excuse seems to become common. Of course, the low deposit rate keeps the household sector jittery, which makes the business strategy of increasing price more likely to succeed. It makes fighting inflation more difficult.

China should switch from relying on increasing deposit reserve ratio to increasing interest rate to contain inflation. The former is unfair to the private sector, making life difficult for SMEs and decreasing household wealth.



Don't exaggerate SME problem

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Lately, many people have suddenly become very caring towards SMEs. The story goes like this: the tightening is causing SMEs to go bankrupt, which could cause an employment crisis. Neither description is correct. SMEs always have financing problems. The same people didn't pay much attention to them before. The purpose of the SME talk is to pressure the central government to loosen up, which would mostly channel money to local governments and property market, not SMEs.

The talk that SMEs are going bankrupt because of the tightening isn't logical at all. Like big companies, SMEs are supposed to be profitable. If they can't get new loans, they can stay with their current businesses and postpone expansion. If the SMEs are going bankrupt because of no new loans, it means they don't make money and stay in business by borrowing more and more. Does it make sense to keep such businesses alive? They will only become bigger problems down the road.

Unfortunately, some SMEs that are going under precisely fall into this category. In the past three years, many coastal private enterprises have switched from manufacturing to financial speculation. Their manufacturing assets have become financing vehicles. The borrowed money has gone into silver, copper, or stock market. The recent declines of such assets have caused havoc among such businesses. Should the government be responsible for bailing out financial speculators?

SME's always have difficulties in raising financing. Every country talks about helping SMEs. But, SMEs always face higher cost of capital. In the end, size does matter in risk. Ceteris paribus, a small company is riskier and must accept higher cost of capital.

As discussed above, China's method of tightening is causing more harm to the SME sector. By limiting credit supply to SoEs and local governments, SMEs face extremely high interest rate in the gray market. To help SMEs, the government should shift to increasing interest rate and opening credit access to anyone who is worthy.

Talking about employment crisis is just a scare tactic. China has manual labor shortage. The coastal export companies that have moved inland have found labor shortage there. China's demographics has changed. There is no endless supply of cheap labor anymore. Three decades of one-child policy is having a big impact on China's labor market. Even if some SMEs go bankrupt, China wouldn't face an employment crisis like a decade ago.

China does have an employment problem with college graduates. But, pushing growth under the existing model wouldn't solve it. The current growth model favors blue collar jobs, because construction and manufacturing always lead. To create more jobs for college graduates, China needs to become more consumption and service oriented. It requires structural reforms, not loose monetary policy.



Inflation is causing social instability

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China's nominal GDP doubled between 2006-2010. The living standard for most people appears to have not risen and has fallen for a considerable portion of the population. As a result mass protests, especially the violent ones, have increased. Pushing growth under the current economic model will only increase social instability.

The benefits from economic growth to the masses are jobs and purchasing power. China is facing manual labor shortage even in central and western provinces. With manual labor shortage, growth isn't important for the first part. It is negative for the second part, as inflation has been higher than wage increase for many people.

Inflation is very negative for household wealth. People save for a rainy day. But, when inflation erodes the value of one's deposit, one's insecurity rises immensely. When wages are not kept up with inflation either, violent social protests are quite likely.



The wrong kind of growth

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GDP growth has become a religion in China. It is automatically assumed to be good. The reality is different. The current growth model channels money to local governments through property market, fees and taxes. The local governments spend the money on projects that they think worthwhile. The money trickles down to the household sector through such projects. But, before the money reaches workers, most are taken away by the middlemen. This is why most people don't feel better off in the past four years even though the nominal GDP has doubled.

Property and food are two areas where people feel hit hardest. When property price is twenty times household annual income, life cannot be that good. One doesn't feel much better when the salary rises by 10 or 20%. It wouldn't make a big difference. The high property price has killed the hope of China's middle class, all for raising revenues for local governments. Could their projects be as important as 1.3 billion people's happiness?

The food safety crisis should be viewed in the context of government squeezing the household sector. The people at the bottom have seen their savings inflated away and income not rising in line with food price. The industry lowers the price to their income level through illegal means. From raw materials like pork and milk to processed foods like bottled water and restaurant meals, the crisis touches most people in the country. It is possibly the single biggest risk to China's social stability.

Inflation is a consequence of China's growth model. It has reached its limits. When money supply rises, it causes asset inflation, which worsens wealth and income inequality, and decreases living standard for most people. To loosen up monetary policy now, without inflation under control, it will cause more social turmoils.

The current growth model is resource intensive. Coal price has risen by over ten times in ten years, twice as fast as nominal GDP. The other resources like iron ore, etc., are similarly appraising twice as fast as China's nominal GDP. This headwind means that China is giving more and more of its growth to resource suppliers, leaving less and less for people. So if China keeps pushing the current growth model through loose monetary policy, more and more of the share from growth will go to other countries. Without changing the growth model, growth itself is just not beneficial to that many people in China anymore.

Now isn't the time to loosen up monetary policy. Instead, China should focus on changing the growth model to keep more of the growth benefit at home and distributed more evenly.

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Posted in: monetary policy